Question

There are four market models:  perfect competition, monopolistic competition, oligopoly and monopoly.  Briefly discuss the assumptions of each of these four models and give examples of each.  Explain the long run economic profit earned by each of the four.  Explain how the concept of economic profit might help explain the rationale for the government’s granting of monopolies to those firms that protect their product with a patent.

Answer 1

Market Structures

            There are four major market structures namely perfect competition, oligopoly, monopolistic competition, and monopoly market structures. Each market structure operates under a unique set of assumptions. Also, each market structure has a unique cost and revenue structures both in the short run and in the long run. The major assumptions, examples and long run economic profit earned under each market structure are discussed below.

Perfect Competition

            Perfect competition is a market that fulfills the following five assumptions. Firstly, there are many firms in the market selling an identical product or service. Secondly, the firms lack price control and hence they act as price takers. Thirdly, due to the large number of firms, each firm controls a relatively small market share. Fourthly, the consumers possess complete market information on services and goods as well as prices. Fifthly, there are not barriers to entry into and out of the market. In the long run, all firms earn normal profits and hence economic profits reduce to zero. An example of a perfect competition market is the fast food industry.

Monopolistic Competition

            Monopolistic market structure characterizes a market in which firms sell similar goods or services that are not perfect substitutes. All the firms in the industry possess low market power uniformly distributed among the market participants. There are low barriers to entry and exit in the market and firms’ decisions do not impact the decisions of other firms. In the long run, economic profit is zero. A good example of a monopolistic competition market is the hotel industry.

Oligopoly Market

            Three salient assumptions define an oligopoly market. Firstly, few firms possess market power and thus control the market. Secondly, firms’ products or services are homogenous but highly differentiated through branding and advertising. Thirdly, the market has barriers to entry and exit. Decisions by one firm significantly impact the decisions of competitors. Firms may earn economic profits in instances of collusion to set price at a point where MR>MC, or the firms may earn zero economic profits in instances of price wars. An example of oligopoly market is the telecommunication industry.

Monopoly Market

            In a monopoly market, there is only one firm in the industry. The firm is the sole producer of an essential good or a service. There are high level barriers to entry into the market thus the existing firm is able to keep off the competition. The firm sets the price for the good or service at a point where MR<MC hence able to earn economic profits in the long run.

            When the government grants patents to a monopoly, it prohibits other firms from selling the product for 17 years. The existing firm can therefore charge a higher price and earn high economic profits. To encourage inventions, the governments grant protection to products as a way of encouraging bringing of new products into the market.